Wednesday, June 28, 2017

Based on the recent data from Kleiner Perkins, there has been a substantial inflection point in the relationship between NASDAQ index valuations and tech IPOs around 2015 that continued into 2016-2017 period.

Over the period 2009-2014, the positive correlation between NASDAQ and global technology IPOs and PE/VC funding was largely a matter of regularity. Starting with 2015, this relationship turned negative. Which means one pesky thing when it comes to the real economy: the great engine of enterprise innovation (smaller, earlier stage companies gaining sunlight) as opposed to behemoths patenting (larger legacy corporations blocking off the sunlight with marginal R&D) is not exactly in a rude health.

Two states and Washington DC are raising their minimum wages comes July 1, with Washington DC’s minimum wage rising to $12.50 per hour, the highest state-wide minimum wage level in the U.S. This development comes after 19 states raised their minim wages since January 1, 2017. In addition, New York and Oregon are now using geographically-determined minimum wage, with urban residents and workers receiving higher minimum wages than rural workers.

Still, one of the most ambitious minimum wage laws currently on the books is that of California. For now, California’s minimum wage (for employers with 26 or more workers) is set us $10.50 per hour (a rise of $0.5 per hour on 2016), which puts California in the fourth place in the U.S. in terms of State-mandated minimum wages. It will increase automatically to $11.00 comes January 1, 2018. Thereafter, the minimum wage is set to rise by $1.00 per annum into 2022, reaching $15.00. From 2023 on, minimum wage will be indexed to inflation. Smaller employers (with 25 or fewer employees) will have an extra year to reach $15.00 nominal minimum wage marker, from current (2017) minimum wage level of $10.00 per hour. All in, in theory, current minimum wage employee working full time will earn $21,840 per annum, and this will rise (again in theory) by $1,040 per annum in 2018. So, again, in theory, nominal earnings for a full-time minimum wage employee will reach $31,200 in 2022.

In cities like San Francisco and Los Angeles, local minim wages are even higher. San Francisco is planning to raise its minim wage to $15.00 per hour in 2018, while Los Angeles is targeting the same level in 2020. This means that in 2018, San Francisco minimum wage workers will be $8,320 per annum better off than the State minimum wage earners, and Los Angeles minim wage earnings will be $4,160 above the State level in 2020.

UC Berkeley research centre for labor economics, http://laborcenter.berkeley.edu/15-minimum-wage-in-california/, does some numbers crunching on the distributional impact of California minimum wages. Except, really, it doesn’t. Why?

Because the problem with minimum wage impact estimates is that it ignores a range of other factors, such as, for example the impacts of minimum wage hikes on substations away from labor into capital (including technological capital), and the impacts of jobs offshoring, etc. While economists can control for these factors imperfectly, it is impossible to know with certainty how specific moves in minimum wages will effect incentives for companies to increase capital intensity of their operations, change skills mix for employees, alter future growth and product development plans, etc.

What we do have, however, is historical evidence to go by. And that evidence is a moving target. In particular, it is a moving target because as minimum wages continue to increase, at some point (we call these inflation points), past historical relationships between wages and hours worked, wages and technological investments, wages and R&D, and so on, change as well.

Take the most recent example of Seattle.

In 2016, Seattle raised its $11.00 per hour minimum wage to $13 per hour, the highest in the U.S. Subsequent protests demanded an increase to $15.00 per hour in 2017. However, research by economists at the University of Washington shows that the wage hike could have
1) Triggered steep declines in employment for low-wage workers, and
2) Resulted in a drop in paid hours of work for workers who kept their jobs.

Overall, these negative impacts have more than cancelled out the benefits of higher wages, so that, on average, low-wage workers now earn $125 per month less than before the minimum wage was hiked in January 2016. In simple terms, instead of rising by $4,160 per annum, minimum wage earners’ wages fell $1,500 per annum, creating the adverse movement in earnings of $5,160. Given current minimum wage earnings, in theory, delivering $27,040 per annum in full time wages, this is hardly an insignificant number. For details of the study, see https://evans.uw.edu/sites/default/files/NBER%20Working%20Paper.pdf.

The really worrying matter is that the empirical estimates presented in the University of Washington studies do not cover longer-term potential impacts from capital deepening and technological displacement of minimum wage jobs, because, put simply, we don’t have enough time elapsing from the latest minimum wage hike. Another worrying matter is that, like the majority of studies before it, the Washington study does not directly control for the effects of Seattle’s booming local economy on minimum wage impacts: as Seattle faces general unemployment rate of 3.2 percent, the adverse impacts of the latest hike in the minimum wages can be underestimated due to the tightness in labor markets.

Now, consider the recent past: in her Presidential bid, Hillary Clinton was advocating a federal minimum wage hike to $12.00 per hour from $7.25 per hour. That was hardly enough for a large number of social activists who pushed for even higher hikes. This tendency amongst activists - to pave the road to hell with good intentions, while using someone else’s money and work prospects - is quite problematic. Econometric analysis of minimum wage effects is highly ambiguous and the expected impacts of minimum wage hikes are highly uncertain ex ante. This ambiguity and uncertainty adversely impacts not only employers, including smaller businesses, but also employees. Including those on minimum wages. It also impacts prospective minimum wage employees who, as Seattle evidence suggests, might face lower prospects of gaining a job. More worrying, the parts of the minimum wage literature that show modest positive impacts from minimum wage hikes are based on the data for minimum wage increases from lower levels to moderate levels, not from high levels to extremely high, as is the case with Seattle, San Francisco, Los Angeles and other cities.

That point seems to be well-reflected in the latest study from the University of Washington. In fact, June 2017 paper results stand clearly contrasted by 2016 study that showed that April 2015 hike in Seattle’s minimum wage from $9.47 per hour to $11.00 per hour was basically neutral in terms of its impact on wages. Losses to those workers who ended up without a job post-minimum wage hike were offset by gains for those worker who kept their employment. In effect, April 2015 hike was a transfer of money from jobs-losing workers to jobs keepers.

In a separate study, from the UC Berkeley labor economics center http://irle.berkeley.edu/seattles-minimum-wage-experience-2015-16/, the researchers found that Seattle’s minimum wage hikes were actually effective in boosting incomes of minimum wage workers, albeit only in one sector: the food industry, and the results are established on a cumulative basis for 2009-2016 period. In addition, University of Washington study used higher quality, more detailed and directly comparable data on minimum wage earners than the UC Berkeley study. However, on the opposite side of the argument, the former study excluded multi-location enterprises, e.g. fast food companies, who are often large scale employers of minimum wage workers. The UC Berkeley study is quite bizarre, to be honest, in so far as it focuses on one sector, while the study from the UofW clearly suggests that wider data is available.

In other words, the UC Berkeley study does not quite contradict or negate the University of Washington study, although it highlights the complexity of analysing minimum wage impacts.

Recent evidence shows a worrying trend of declining popular support for the traditional liberal democracy across a range of Western societies. This decline is more pronounced for the younger cohorts of voters. The prevalent theories in political science link this phenomena to a rise in volatility of political and electoral outcomes either induced by the challenges from outside (e.g. Russia and China) or as the result of the aftermath of the recent crises. These views miss a major point: the key drivers for the younger generations’ skepticism toward the liberal democratic values are domestic intergenerational political and socio-economic imbalances that engender the environment of deep (Knightian-like) uncertainty. This distinction – between volatility/risk framework and the deep uncertainty is non-trivial for two reasons: (1) policy and institutional responses to volatility/risk are inconsistent with those necessary to address rising deep uncertainty and may even exacerbate the negative fallout from the ongoing pressures on liberal democratic institutions; and (2) investors cannot rely on traditional risk management approaches to mitigate the effects of deep uncertainty. The risk/volatility framework view of the current political trends can result in amplification of the potential systemic shocks to the markets and to investors through both of these factors simultaneously. Despite touching on a much broader set of issues, this note concludes with a focus on investment strategy that can mitigate the rise of deep political uncertainty for investors.

Back in 1954, an economist, Armen A. Alchian, working at RAND conducted the world’s first event study. His study used stock market data, publicly available at the time, to infer which fissile fuel material was used in manufacturing highly secret H-bomb. That study was immediately withdrawn from public view. The paper linked above replicates Alchian's results.

Friday, June 16, 2017

Continuing with the theme on 'What I've been reading lately?', here is a smashing paper on 'accuracy' of empirical economic studies.

The paper, authored by Hou, Kewei and Xue, Chen and Zhang, Lu, and titled "Replicating Anomalies" (most recent version is from June 12, 2017, but it is also available in an earlier version via NBER) effectively blows a whistle on what is going on in empirical research in economics and finance. Per authors, the vast literature that detects financial markets anomalies (or deviations away from the efficient markets hypothesis / economic rationality) "is infested with widespread p-hacking".

What's anomalies? Anomalies are departures in the markets (e.g. in share prices) from the predictions generated by the models consistent with rational expectations and the efficient markets hypothesis. In other words, anomalies occur when markets efficiency fails.

There are scores of anomalies detected in the academic literature, prompting many researchers to advocate abandonment (in all its forms, weak and strong) of the idea that markets are efficient.

Hou, Xue and Zhang take these anomalies to the test. The compile "a large data library with 447 anomalies". The authors then control for a key problem with data across many studies: microcaps. Microcaps - or small capitalization firms - are numerous in the markets (accounting for roughly 60% of all stocks), but represent only 3% of total market capitalization. This is true for key markets, such as NYSE, Amex and NASDAQ. Yet, as authors note, evidence shows that microcaps "not only
have the highest equal-weighted returns, but also the largest cross-sectional standard deviations
in returns and anomaly variables among microcaps, small stocks, and big stocks." In other words, these are higher risk, higher return class of securities. Yet, despite this, "many studies
overweight microcaps with equal-weighted returns, and often together with NYSE-Amex-NASDAQ
breakpoints, in portfolio sorts." Worse, many (hundreds) of studies use 1970s regression technique that actually assigns more weight to microcaps. In simple terms, microcaps are the most common outlier and despite this they are given either same weight in analysis as non-outliers or their weight is actually elevated relative to normal assets, despite the fact that microcaps have little meaning in driving the actual markets (their weight in the total market is just about 3% in total).

So the study corrects for these problems and finds that, once microcaps are accounted for, the grand total of 286 anomalies (64% of all anomalies studied), and under more strict statistical signifcance test 380 (of 85% of all anomalies) "including 95 out of 102 liquidity variables (93%) are insignificant at the 5% level." In other words, the original studies claims that these anomalies were significant enough to warrant rejection of markets efficiency were not true when one recognizes one basic and simple problem with the data. Worse, per authors, "even for the 161 significant anomalies, their magnitudes are often much lower than originally reported. Among the 161, the q-factor model leaves 115 alphas insignificant (150 with t < 3)."

This is pretty damning for those of us who believe, based on empirical results published over the years, that markets are bounded-efficient, and it is outright savaging for those who claim that markets are perfectly inefficient. But, this tendency of researchers to silverplate statistics is hardly new.

Hou, Xue and Zhang provide a nice summary of research on p-hacking and non-replicability of statistical results across a range of fields. It is worth reading, because it dents significantly ones confidence in the quality of peer review and the quality of scientific research.

As the authors note, "in
economics, Leamer (1983) exposes the fragility of empirical results to small specification changes,
and proposes to “take the con out of econometrics” by reporting extensive sensitivity analysis to
show how key results vary with perturbations in regression specification and in functional form." The latter call was never implemented in the research community.

"In
an influential study, Dewald, Thursby, and Anderson (1986) attempt to replicate empirical results
published at Journal of Money, Credit, and Banking [a top-tier journal], and find that inadvertent errors are so commonplace
that the original results often cannot be reproduced."

"McCullough and Vinod (2003)
report that nonlinear maximization routines from different software packages often produce very
different estimates, and many articles published at American Economic Review [highest rated journal in economics] fail to test their
solutions across different software packages."

"Chang and Li (2015) report a success rate of less than
50% from replicating 67 published papers from 13 economics journals, and Camerer et al. (2016)
show a success rate of 61% from replicating 18 studies in experimental economics."

"Collecting more than 50,000 tests published in American Economic Review, Journal of Political
Economy, and Quarterly Journal of Economics, [three top rated journals in economics] Brodeur, L´e, Sangnier, and Zylberberg (2016) document
a troubling two-humped pattern of test statistics. The pattern features a first hump with
high p-values, a sizeable under-representation of p-values just above 5%, and a second hump with
p-values slightly below 5%. The evidence indicates p-hacking that authors search for specifications
that deliver just-significant results and ignore those that give just-insignificant results to make their
work more publishable."

If you think this phenomena is encountered only in economics and finance, think again. Here are some findings from other ' hard science' disciplines where, you know, lab coats do not lie.

"...replication failures have been widely documented across scientific disciplines in the
past decade. Fanelli (2010) reports that “positive” results increase down the hierarchy of sciences,
with hard sciences such as space science and physics at the top and soft sciences such as psychology,
economics, and business at the bottom. In oncology, Prinz, Schlange, and Asadullah (2011) report
that scientists at Bayer fail to reproduce two thirds of 67 published studies. Begley and Ellis (2012)
report that scientists at Amgen attempt to replicate 53 landmark studies in cancer research, but
reproduce the original results in only six. Freedman, Cockburn, and Simcoe (2015) estimate the economic
costs of irreproducible preclinical studies amount to about 28 billion dollars in the U.S. alone.
In psychology, Open Science Collaboration (2015), which consists of about 270 researchers, conducts
replications of 100 studies published in top three academic journals, and reports a success rate of
only 36%."

Let's get down to real farce: everyone in sciences knows the above: "Baker (2016) reports that 80% of the respondents in a survey of 1,576 scientists conducted
by Nature believe that there exists a reproducibility crisis in the published scientific literature. The
surveyed scientists cover diverse fields such as chemistry, biology, physics and engineering, medicine,
earth sciences, and others. More than 70% of researchers have tried and failed to reproduce another
scientist’s experiments, and more than 50% have failed to reproduce their own experiments.
Selective reporting, pressure to publish, and poor use of statistics are three leading causes."

Yeah, you get the idea: you need years of research, testing, re-testing and, more often then not, you get the results are not significant or weakly significant. Which means that after years of research you end up with unpublishable paper (no journal would welcome a paper without significant results, even though absence of evidence is as important in science as evidence of presence), no tenure, no job, no pension, no prospect of a career. So what do you do then? Ah, well... p-hack the shit out of data until the editor is happy and the referees are satisfied.

Which, for you, the reader, should mean the following: when we say that 'scientific research established fact A' based on reputable journals publishing high quality peer reviewed papers on the subject, know that around half of the findings claimed in these papers, on average, most likely cannot be replicated or verified. And then remember, it takes one or two scientists to turn the world around from believing (based on scientific consensus at the time) that the Earth is flat and is the centre of the Universe, to believing in the world as we know it to be today.

Full link to the paper: Charles A. Dice Center Working Paper No. 2017-10; Fisher College of Business Working Paper No. 2017-03-010. Available at SSRN: https://ssrn.com/abstract=2961979.

Not normally my cup of tea, but Valdai Club work is worth following for all Russia watchers, regardless of whether you agree or disagree with Moscow-centric worldview (and whether you agree or disagree that such worldview even exists). So here is a recent paper on Trump's Administration and the context of the Washington's search for new positioning in the geopolitical environment where asymmetric influence moves by China, Russia and India, as well as by smaller players, e.g. Iran and Saudis, are severely constraining the neo-conservative paradigm of the early 2000s.

Wednesday, June 14, 2017

As promised in the previous post, a quick update on Fed’s latest guidance regarding its plans to unwind the $4.5 trillion sized balance sheet, to the Quantitative un-Easing...

First, the size and the composition of the problem:

So, as noted in the post here: http://trueeconomics.blogspot.com/2017/06/13617-unwinding-mess-ecb-vs-fed.html, the Fed is aiming to gradually unwind the size of its assets exposures on both, the U.S. Treasuries and MBS (mortgage-backed securities). This is a tricky task, because simply dumping both asset classes into the markets (aka, selling them to investors) risks pushing yields on Government debt up and value of Government bonds down, as well as the value of MBS assets down. The problem with this is that all of these assets are systemically important to… err… systemically important financial institutions (banks, pension funds, investment funds and insurance companies).

Should yields on Government debt explode due to the Fed selling, the U.S. Government will simultaneously: 1) pay more on its debt; and 2) get less of rebates from the Fed (the returned payments on debt held by the Fed). This would be ugly. Uglier yet, the value of these bonds will fall, creating pressure on the assets valuations for assets held by banks, investment funds, insurance companies and pensions funds. In other words, these institutions will have to accumulate more assets to cover their capital cushions and/or sustain their funds valuations. Or they will have to reduce lending and provision of payouts.

Should MBS assets decline in value, there will be an assets write down for private sector financial institutions holding them. The result will be the same as above: less lending, more expensive credit and lower profit margins.

With this in mind, today’s Fed announcement is an interesting one. The FOMC “currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated,” according to today’s statement. And the FOMC provides some guidance to this normalization program:

Instead of dumping assets into the market, the Fed will try to gradually shrink the balance sheet by ‘rolling off’ a fixed amount of assets every month. At the start, the Fed will ‘roll off’ $10 billion a month, split between $6 billion from Treasuries and $4 billion from MBS. Three months later, the numbers will rise to $20 billion per month: $12 billion for Treasuries and $8 billion for MBS. Subsequently, ‘roll-offs’ will rise $10 billion per month ever three months ($6 billion for Treasuries and $4 billion for MBS). The ‘roll-off’ will be capped once it reaches $30 billion for Treasuries and $20 billion for MBS.

This modestly-paced plan suggests that the ‘roll off’ will concentrate on non-replacement of maturing instruments, rather than on direct sales of existent instruments.

Predictably (in line with the median investors’ outlook) the Fed raised its base rate and provided more guidance on their plans to deleverage the Fed’s balance sheet (more on the latter in a subsequent post). The moves came against a revision of short term forecast for inflation (inflationary expectations moved down) and medium turn sustainable (or neutral) rate of unemployment (unemployment target moved down); both targets suggesting the Fed could have paused rate increase.

Rate hike was modest: the Federal Open Market Committee (FOMC) increased its benchmark target by a quarter point, so the new rate range will be 1 percent to 1.25 percent, against the previous 0.91 percent. This marks the third rate hike in 6 months and the Fed signalled that it is on track to hike rates again before the end of the year (with likely date for the next hike in September). The forecast for 2018 is for another 75 basis points rise in rates, unchanged on March forecast.

Interestingly, the Fed statement highlights that inflation (short term expectations) remains subdued. “Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the committee’s 2 percent objective over the medium term,” the FOMC statement said. This changes the tack on previous months’ statements when the Fed described inflationary outlook as “broadly close” to target. Data released earlier today showed core consumer price inflation (ex-food and energy) slowed in May for the fourth straight month to 1.7 percent y-o-y. This is below the Fed target rate of 2 percent and suggests that monetary policy is currently running countercyclical to inflation. On expectations side, FOMC lowered its median forecast for inflation to 1.6 percent in 2017, from 1.9 percent forecast published in March. The FOMC left its forecasts for 2018 and 2019 unchanged at 2 percent.

The Fed, therefore, sees inflation slump to be temporary, which prompted U.S. 2 year yields to move sharply up:

Source: @Schuldensuehner

Which means that today’s hike was not about inflationary pressures, but rather unemployment, which dropped to a 16-year low at 4.3 percent in May.

As labour markets continue to overheat (we are now at 4.2 percent forecast 2017 unemployment and with over 1 million vacancies postings in excess of jobs seekers, suggesting a substantial and rising gap between the low quality of remaining skills on offer and the demand for higher skills), the Fed dropped its estimate of the neutral rate of unemployment (or, in common terms, the estimated minimum level of unemployment that can be sustained without a major uptick in wages inflation), from 4.7 percent in march to 4.6 percent today. At which point, it is worth noting the surreality of this number: the estimate has nothing to do with realistic balancing out of skills supply and demand, and is mechanically adjusted to match evolving balance between actual unemployment trends and inflation trends. In other words, the neutral rate of unemployment is Fed’s voodoo metric for justifying anything. How do I know this? Ok, consider the following forecasts & outlook figures from FOMC:

2017 GDP growth at 2.2% compared to 2.1%, unemployment rate at 4.2% compared to 4.5% prior, and core inflation at 2.0%, same as prior. So growth outlook is, basically, stable, but unemployment is dropping and inflation not budging.

In other words, it no longer matters what the Fed forecasts for growth and unemployment, inflation stays put; and it doesn’t matter what it forecast for growth and inflation, unemployment drops, and you can stop worrying about joint forecast for inflation and unemployment, growth remains remarkably stable. It’s the New Normal of Alan Greenspan Redux.

The FOMC next meets in six weeks, on July 25-26. Here is the dots chart of Fed’s expectations on benchmark rate compared to previous:

The key takeaway from all of this is that the Fed is currently at a crossroads: the uncertainty about key economic indicators remains elevated, as the Fed is compressing 2017-2018 guidance on rates. In other words, more certainty signalled by the Fed runs against more uncertainty signalled by the economy. Go figure…

U.S Treasury latest figures (through May 2017) for Federal Government’s fiscal (I’m)balance are an interesting read this year for a number of reasons. One of these is the promise of fiscal responsibility and cutting of public spending and deficits made by President Trump and the Republicans during last year’s campaigns. The promise that remains, unfortunately, unfulfilled.

In May 2017, cumulative fiscal year-to-date Federal Government receipts amounted to $2.169 trillion, which is $30 billion higher than over the same period of 2016. However, Federal Government’s gross outlays in the first 8 months of this fiscal year stood at $2.602 trillion, of $57.345 billion above the same period of last year.As a result, Federal deficit in the first 8 months of FY 2017 rose to $432.853 billion, up 6.77% y/y or $27.44 billion.

Given that 4 out of the 8 months of FY 2017 were under the Obama Presidency tenure, the above comparatives are incomplete. So consider the four months starting February and ending May. Over that period of 2017, Federal deficit stood at $274.274 billion, up 11.17% or $27.569 billion on February-May for FY 2016. In this period, in 2017, Trump Administration managed to spend $51.9 billion more than his predecessor’s presidency.

You can see more detailed breakdown of expenditures and receipts here: https://www.fiscal.treasury.gov/fsreports/rpt/mthTreasStmt/mts0517.pdf but the bottom line is simple: so far, four months into his presidency, Mr. Trump is yet to start showing any signs of fiscal discipline. Which raises the question about his cheerleaders in Congress: having spent Obama White House years banging on about the need for responsible financial management in Washington, the Republicans are hardly in a rush to start balancing the books now that their party is in control of both legislative and, with some hefty caveats, the executive branches.

Sunday, June 11, 2017

The happiness and the unbearable sunshine of Spring is basking the monetary dreamland of the advanced economies... Based on the latest data, world's 'leading' Central Banks continue to prime the pump, flooding the carburetor of the global markets engine with more and more fuel.

According to data collated by Yardeni Research, total asset holdings of the major Central Banks (the Fed, the ECB, the BOJ, and PBOC) have grown in April (and, judging by the preliminary data, expanded further in May):

May and April dynamics have been driven by continued aggressive build up in asset purchases by the ECB, which now surpassed both the Fed and BOJ in size of its balancesheet. In the euro area case, current 'miracle growth' cycle requires over 50% more in monetary steroids to sustain than the previous gargantuan effort to correct for the eruption of the Global Financial Crisis.

Meanwhile, the Fed has been holding the junkies on a steady supply of cash, having ramped its monetary easing earlier than the ECB and more aggressively. Still, despite the economy running on overheating (judging by official stats) jobs markets, the pride first of the Obama Administration and now of his successor, the Fed is yet to find its breath to tilt down:

Which is clearly unlike the case of their Chinese counterparts who are deploying creative monetarism to paint numbers-by-abstraction picture of its balancesheet.

To sustain the dip in its assets held line, PBOC has cut rates and dramatically reduced reserve ratio for banks.

And PBOC simultaneously expanded own lending programmes:

All in, PBOC certainly pushed some pain into the markets in recent months, but that pain is far less than the assets account dynamics suggest.

Unlike PBOC, BOJ can't figure out whether to shock the worlds Numero Uno monetary opioid addict (Japan's economy) or to appease. Tokyo re-primed its monetary pump in April and took a little of a knock down in May. Still, the most indebted economy in the advanced world still needs its Central Bank to afford its own borrowing. Which is to say, it still needs to drain future generations' resources to pay for today's retirees.

So here is the final snapshot of the 'dreamland' of global recovery:

As the chart above shows, dealing with the Global Financial Crisis (2008-2010) was cheaper, when it comes to monetary policy exertions, than dealing with the Global Recovery (2011-2013). But the Great 'Austerity' from 2014-on really made the Central Bankers' day: as Government debt across advanced economies rose, the financial markets gobbled up the surplus liquidity supplied by the Central Banks. And for all the money pumped into the bond and stock markets, for all the cash dumped into real estate and alternatives, for all the record-breaking art sales and wine auctions that this Recovery required, there is still no pulling the plug out of the monetary excesses bath.

As the chart above clearly shows, the number of reporter/disclosed attacks has exploded, staring with 2014, and the volume of attacks (data files impacted) has blown out starting 2010 (note: Yahoo attacks were severely lagged in reporting). In part, the two factors are down to changes in reporting and disclosure rules, and in part they are down to changes in reporting practices. But, as we observe econometrically in our recent papers on the subject: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2892842 and https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2904749, the pattern on frequency, severity and impact of attacks, as well as their typology, are richer than the chart above provides.

Starting with 2010s, the typology of cyber security risks and attacks has been shifting from malicious and accidental losses of hardware and accidental disclosures of data to malware-based hacks, direct hacks, and illegal disclosures. The distribution of attacks has been changing since 2014, with smaller and larger, state and private sector players being hit with higher frequency, as opposed to the 2000s-early 2010s when we had more concentrated distribution of attacks. And, crucially, the impact of the attacks is also changing: starting with 2014, we are witnessing systemic shocks contagion propagating from individual attack targets to their exchanges and even to other exchanges.

Saturday, June 10, 2017

Let’s start thinking. The U.S. Treasury yields are underlying the global measure of inflation since the onset of the global ‘fake recovery’. Both have been and are still trending to the downside. Sounds plausible for a ‘hedge’ asset against global economic stagnation. And the U.S. Treasuries can be thought of as such, given the U.S. economy’s lead-timing for the global economy. Except for a couple of things:

U.S. Treasury is literally running out of money (by August, it will need to issue new paper to cover arising obligations and there is a pesky problem of debt ceiling looming again);

U.S. Fed is signalling two (or possibly three) hikes over the next 6 months and (even more importantly) no willingness to restart buying Treasuries again;

U.S. political risks are rising, not abating, and (equally important) these risks are now evolving faster than global geopolitical risks (the hedge’ is becoming less ‘safe’ than the risks it is supposed to hedge);

U.S. Fed is staring at the prospect of potential increase in decisions uncertainty as it is about to start welcoming new members ho will be replacing the tried-and-trusted QE-philes;

Meanwhile, the gap between the Fed policy’s long term objectives and the reality on the ground is growing: private debt is rising, financial assets valuations are spinning out of control and

So as the U.S. 10-year paper is nearing yields of 2%, and as the premium on Treasuries relative to global inflation is widening once again, the U.S. Fed is facing a growing problem: tightening rates is necessary to restore U.S. dollar (and U.S. Treasuries) credibility as a global risk hedge (the key reason anyone wants to hold these assets), but raising rates is likely to take the wind out of the sails of the financial markets and the real economy. Absent that wind, the entire scheme of debt-fuelled growth and recovery is likely to collapse.

Cart is flying one way. Rails are pointing the other. And no one is calling it a crash… yet…

As noted in the previous post, covering the topic of continued mis-pricing by equity markets of policy uncertainties, much of the decline in the Global Economic Policy Uncertainty Index has been accounted for by a drop in European countries’ EPUIs. Here are some details:

In May 2017, EPU indices for France, Germany, Spain and the UK have dropped significantly, primarily on the news relating to French elections and the moderation in Brexit discussions (displaced, temporarily, by the domestic election). Further moderation was probably due to elevated level of news traffic relating to President Trump’s NATO visit. Italy’s index rose marginally.

Overall, European Index was down at 161.6 at the end of May, showing a significant drop from April 252.9 reading and down on cycle high of 393.0 recorded in November 2016. The index is now well below longer-term cycle trend line (chart below).

However, latest drop is confirming overall extreme degree of uncertainty volatility over the last 18 months, and thus remains insufficient to reverse the upward trend in the ‘fourth’ regime period (chart below).

Despite post-election moderation, France continues to lead EPUI to the upside, while Germany and Italy remain two drivers of policy uncertainty moderation. This is confirmed by the period averages chart below:

Overall, levels of European policy uncertainty remain well-above pre-2009 averages, even following the latest index moderation.

Wednesday, June 7, 2017

There has been some moderation in the overall levels of Economic Policy Uncertainty, globally, over the course of May. The decline was primarily driven by European Uncertainty index falling toward longer-term average (see later post) and brings overall Global EPU Index in line with longer term trend (upward sloping):

This meant that short-term correlation between VIX and Global EPUI remained in positive territory for the second month in a row, breaking negative correlations trend established from October 2015 on.

The trends in underlying volatility of both VIS and Global EPUI remained largely the same:

The key to the above data is that equity markets risk perceptions remain divorced from political risks and uncertainties reflected in the Global EPUI. This is even more apparent when we consider actual equity indices as done below:

Both, on longer-run trend comparative and on shorter term level analysis bases, both S&P 500 and NASDAQ Composite react in the exactly opposite direction to Global Economic Policy Uncertainty measure: rising uncertainty in the longer run is correlated with rising equities valuations.

Latest data from FactSet on S&P500 core metrics is an interesting read. Here are a couple of charts that caught my attention:

Look first at the last 6 months worth of EPS data through estimated 2Q 2017 (based on 99% of companies reporting). The trend continues: EPS is declining, while prices are rising. On a longer time scale, EPS have been virtually flat in 2014-2016, but are forecast to rise nicely in 2017 and 2018. Whatever the forecast might be for 2018, 2017 increase would do little to generate a meaningful reversion in EPS to price trend

However, the good news is, expectations on rising EPS are driven by rising sales for 2017, and to a lesser extent in 2018. This would be (if materialised) an improvement on the 2014-2016 core drivers, including shares repurchases (chart below).

Next, consider P/E ratios:

As the chart above indicates, P/E ratios are expected to continue rising in the next 12 months. In other words, the markets are going to get more expensive, relative to underlying earnings. Worse, on a 5-year average basis, all sectors, excluding Financials, are at above x14. Hardly a comfort zone for 'go long' investors. The overvalued nature of the market is clearly confirmed by both forward and trailing P/E ratios over the last 10 years:

Forward expectations are now literally a run-away train, relative to the past 10 years record (chart above), while trailing (lagged) P/Es are dangerously close to crisis-triggering levels of exuberance (chart below).

In summary, thus, latest data (through end-of-May) shows continued buildup of risks in the equity markets. At what point the dam will crack is not something I can attempt to answer, but the lake of investors' expectations is now breaching the top, and the spillways aren't doing the trick on abating them.

Tuesday, June 6, 2017

U.S. withdrawal from Paris Climate Accord has been described by various policymakers, analysts and journalists around the world as a travesty, betrayal of the environment, and the surrender of the U.S. leadership (from undefinable 'global leadership' to historically incorrect 'environmental leadership'). In reality, it is none of the above, despite the fact that it does not bode well for the future of environmental policies worldwide and for the environment in general.

Paris Agreement: Taking an Unnecessary 'Exit' Route

The reasons for why the U.S. 'exit' from Paris deal is more rhetorical than tangible are numerous, but here are some major ones.

1) Paris COP21 Agreement was never ratified by the U.S. so, technically-speaking, the Trump Administration has managed to 'exit' what the U.S. has not 'entered' into in the first place. Let me explain, briefly: the Paris climate agreement (the Paris COP21 Agreement) was "adopted" via a Presidential executive order on September 2016. This raised a range of questions - at the time barely-covered by the media - as to the validity of such an order. Unlike normal executive orders, the Treaty adoption was committing the U.S. to an agreement with a four-year breaking clause period, thus de facto binding the one-over Presidential Administration to Obama Administration order. In contrast to the U.S., all other signatories to the agreement required ratification by their legislatures or via other constitutionally-stipulated procedures. The U.S. was unique, to-date, in not seeking domestic ratification.

A constitutional position - that the Paris treaty should not be treated as an ordinary 'executive order' agreement was expressed by some legal scholars who view the Paris agreement as more than a simple executive agreement. Bodansky (2016) points to the fact that COP21 adoption via an executive order belongs to a category of commitments that "have a long, heretofore undiscovered [constitutional] pedigree." In other words, the actual act of 'adoption' of the Paris agreement by the U.S. can be legally shaky and it is shaky especially given that there is clearly not a chance that the COP21 can be ratified by the current Congress.

As the result, Trump Administration did not claw back on U.S. international commitment, but it did renege on President Obama's international commitment. The U.S. is not equivalent to President Obama, unless we get comfortable with an idea of Presidents residing above the Constitution. Which, given the current White House resident, might be the case of 'watch what you wish for'.

2) President Trump has committed to withdrawing from the agreement some time in late 2020, and potentially, given the questionable constitutionality of the agreement validity in the first place, some time after that or never. The Paris Agreement allows withdrawal only following a four year delay period, after the agreement coming into power. If the U.S. adoption of the agreement requires approval by the Congress, the actual date of the treaty coming into power can be set as the date of such an approval. And the four year delay period will have to start from that date. I am not a legal scholar, so I am speculating on this, but it might just be the case that the U.S. might technically remain within Paris agreement past 2020 election and into the next Administration.

3) Now, consider the gargantuan misrepresentation of the nature of the Paris agreement by the Trump Administration. The President made repeated statements that Paris agreement imposes severe burdens on the U.S. economy, with potential for costing some 2.7 million American jobs. In reality, the agreement is a non-binding and non-enforceable commitment. If the U.S. faced with severe damages to its economy from Paris commitments, instead of withdrawing from the accord, the Washington could simply reduce promised deliverables and let its emissions reduction targets lapse. There would have been no repercussions for the U.S., beyond bad PR (the same bad PR that is already forthcoming). In fact, one of the reasons that Nicaragua (one of only two non-signatories, alongside Syria) refused to join the agreement was that the SOP21 lacked meaningful enforcement and had no commitment obligations with respect to targets.

In other words, Trump Administration 'exited' an accord that had, materially, no legally binding power to change anything. Which also flies in the face of the President claiming he can re-negotiate U.S. position in the Paris agreement. Why would you need to renegotiate that which can be changed unilaterally at will?

As the Paris Agreement is a non-binding and non-enforceable, calling the U.S. participation in it an example of U.S. 'leadership' is nonsense. Calling the U.S. withdrawal from it a 'tragedy' is a case of hysterical overreaction. And, equally, calling it 'draconian' in terms of its potential impact on the U.S. is pure demagoguery.

Policies, not Non-binding Treaties, Matter

What really is of concern here is not the U.S. participation or non-participation in the Paris COP21 Agreement, but the Administration's policies on the environment, including matters relating to President Trump's desire to 'resurrect' the U.S. coal industry, and his push for more oil and gas production, as well as his attitudes to the EPA, the plans to open up commercial and mining / extraction development on protected Federal lands, etc, etc, etc.

These policies are worth criticising and fretting about. COP21 is only tangentially material to them.

In fact, President Trump's obsession with making 'coal great again' is worrying not only from environmental perspective, but also from economic development perspective, and it exemplifies the Administration's bizarre view of the U.S. economy. For a number of reasons, which I don't have room to discuss here at length, but are worth mentioning in passing.

Much of the decline in coal's fortunes from 2012 on is accounted for by non-environmental policy factors. As the report shows, growth in energy supply from natural gas accounted for 49 percent of the total market share loss accruing to coal. Further 26 percent of coal's decline was down to a drop in overall demand, and 18 percent was accounted for by renewables. Only 3-5 percent of coal's market share decline was down to Obama Administration's environmental regulations.

Someone has told President Trump a porky: clawing back on Obama's environmental regulations would have saved, at most, only 2,900 coal miners jobs out of 58,000 lost during the 2012-2016 period. Though even that figure is highly questionable, as research linked above suggests that the true number of jobs saved would be closer to 1,700.

Here's a chart from the above-linked study estimating jobs impact of the President Trump's policies favouring coal:

The U.S. leadership on the environment comes through with all its shoddy 'glory' in coal's fortunes history. High coal prices in the first decade of the century were driven by the demand for energy from China and, arguably, by sky high global price of oil. As Chinese demand fell, starting, in 2011, the U.S. environmental leadership turned out to have little to do with globally collapsing demand for coal and coal prices or with an ongoing substitution away from more CO2-intensive fossil fuels in the global energy production mix. Active Chinese shift away from coal to other sources of energy plus decline in the rate of growth on Chinese energy demand drove down global prices, accounting for almost half of the entire decline in the U.S. (and global) coal's fortunes.

In simple terms, coal hardly makes any sense as a target for either investment, or jobs creation, or economic value added creation. Not because the U.S. is leading the world on the environmental policies, but because China is shifting its energy mix toward cleaner alternatives. Worse, improving coal demand outlook makes even less sense for an Administration that actively promotes more gas production and exports. President Trump is missing the main point of changing global economy: no one wants coal anymore. Nor do many want more supplies of oil and gas, as clearly evidenced by collapse in worldwide prices of these sources of energy.

Another point shows that the alleged U.S. leadership on environmental policies has been bogus at best, even during the 'environmentally conscious' Obama era. The very reason why the COP21 Agreement was left without an enforceable commitment mechanism and with a unilaterally adjustable targets is... the U.S. push for these features of the agreement. During the treaty negotiations, it was the U.S. that insisted on undermining the treaty strengths in order to increase the number of signatories. And although the U.S. was one of the countries that insisted on public monitoring of the Paris Agreement progress, such insistence was little more than rhetorical, given the fact that global research into CO2 emissions would have provided de facto public disclosure of countries' progress.

COP21: A Problem Was Always Bigger than the Solution

Confused, yet? You shouldn't be. The problem with the Paris agreement is the same as the problem with the U.S. 'leadership' on the environment and is identical to the broader problem of so-called global 'leadership' on the environment: there is no material will on behalf of core countries (including the U.S., but excluding Europe) to do anything serious about setting, achieving and enforcing robust and meaningful environmental targets.

Paris agreement in and by itself is a fig leaf of decorum. Being a part of it or being outside of it are rhetorical positions, more designed to shore up symbolism of 'something being done', than actually doing what would be needed to address a wide-ranging case of environmental degradation and depletion of the natural capital. Note: environmental problems vastly exceed carbon emissions, alone, despite the fact that media and politicians are hell-bent on talking primarily about carbon.

Which brings us to another mystery, worth mentioning in passim, again due to space constraints. What constituency does President Trump serve in withdrawing from the agreement? Not getting drawn into speculating about the right- v left- wing opportunism, here are the simple facts: the Paris Agreement is more popular than the President himself. November 2016 survey by the Yale University showed broad-based support for the treaty and the U.S. participation in it. Some snapshots from the survey:

69% of registered voters said "the U.S. should participate in the international agreement to limit climate change (the Paris COP21 agreement), compared with only 13% who say the U.S. should not";

66% of registered voters "say the U.S. should reduce its greenhouse gas emissions, regardless of what other countries do", aka independent of the COP21;

"A majority of registered voters want President-elect Trump (62%) and Congress (63%) to do more to address global warming";

"A majority of registered voters say corporations and industry should do more to address global warming (72% of all registered voters; 87% of Democrats, 66% of Independents, and 53% of Republicans)". Which means that, based on party affiliation, in each party, including the Republican party, majority of voters support greater action on global warming;

When it comes to 'making coal great again', 70% of U.S. registered voters "support setting strict carbon dioxide emission limits on existing coal-fired power plants to reduce global warming and improve public health, even if the cost of electricity to consumers and companies would likely increase – a core component of the EPA’s Clean Power Plan. Democrats (85%), Independents (62%) and Republicans (52%) all support setting strict limits on these emissions". Again, we have majority support even amongst the Republicans;

"A large majority of registered voters say the Federal government should prepare for the impacts of global warming, prioritizing impacts on public water supplies (76%), agriculture (75%), people’s health (74%), and the electricity system (71%)".

Carbon intensity of the global economy will continue to fall, irrespective of whether the U.S. presidential administration likes it or not. The reasons for this go beyond simple carbon accounting, and deeper into the issues of public health, quality of life and changing energy intensities of production. The transfer is happening not from the U.S. to foreign destinations, but from the U.S. carbon-intensive economy to the U.S. carbon-reducing economy. The same transfer is happening in other economies. Here's an OECD report on the trend and potential for such transfers. More partisan on the issue NDRC had this report on jobs generation in the alternative energy sector.

Reductions in carbon intensity of production are not a zero sum game, but rather create opportunities for innovation, increasing value added, deepening the customer base and improving efficiencies in production and investment. Environmental market worldwide is estimated at USD 1.4 trillion in just 'advanced energy' segment, of which the U.S. domestic market accounts for just 1/7th. Cleantech market size is USD 6.4 trillion, and so on. An example of the opportunity space open for business investment and development in the environmental services, energy and manufacturing sectors is so significant that days after President Trump's decision to exit COP21, the State of California signed a long-term agreement with China to engage in joint development of "climate-positive" technologies and emissions trading. Ironically, few years back, Chinese carbon permits system drove the global carbon markets off the cliff. Today, Beijing is trying to position itself as a positive player in rebooting these markets.

Environmental protection (and policies aimed at alleviating the adverse impact of global warming) is more than a market for new goods and services. From both economic and (more importantly) social perspectives, it is also about improving quality of air, quality of water (e.g. here and here), public health (for example, here) and food security (e.g. here and here). In the end, treating environment as part of our productive, long-term investable, tangible capital, is more about preventing future social suffering and unrest than about earning profits. But, even for those politicians solely concerned with jobs and financial or economic bottomline, the case for environmental protection-led economic development is very strong.

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So the really puzzling matter for the Trump Administration and the U.S. political elites (namely the Republicans' dominated Congress) is: what on Earth are they doing in dismantling the environmental policies in a wholesale fashion?

President Trump, and a range of his advisers, appear to believe that environmental policies are zero-sum game, transferring income, wealth and jobs from 'traditional' (carbon-intensive) sectors of the U.S. economy to foreign competitors. Which is simply false. For a number of reasons, again worth touching here:

Incidentally, China's commitments (or pledges) prior to the COP21 clearly show that its leadership sees all three of the above points as salient for the country future. Back in 2014, the Chinese government has promised to peak its emission by or before 2030, first time ever setting a deadline for peak emissions. It also promised to increase the renewables share in its energy mix to 20% by the same date. Doing this will require China to instal some 800-1000 gigawatts of carbon-free energy generation capacity, or more than its current coal capacity and close to the total current market size for electricity generation in the U.S. The Obama Administration claimed credit for 'bringing China' to agree on these environmental targets, but reality is quite different: Beijing is desperate to clean up its urban environment, claw back on severe pollution of its water sources and secure some sort of sustainable agriculture and food production. Of course, not is well on the Chinese front either. As a side note, those who are worried about China taking the leadership jersey from the U.S. on environment, should read this report: like the U.S., China is producing more rhetoric than action.

In short, the problem of addressing huge gaps between political rhetoric and the reality of our deteriorating global environment remains insurmountable to our political leaders. President Trump's extreme position on COP21 is just an outlier to the cluster of politicians worldwide who are strong on promises and media soundbites, yet unable and unwilling to develop a global policy framework that can deliver measurable, enforceable and transparent commitments on the environment. The problem of finding a solution to continued depletion of our natural capital around the world remains larger than COP21. With the U.S. 'leadership' in it, or without.

Disclaimer

This blog represents my personal views and is not reflective of the views or opinions held by any company, contractor, client or employer I work for currently or have worked for in the past. These views are not an endorsement to take any action in the markets or of any political position, figures or parties.

“It is not true that people stop pursuing dreams because they grow old, they grow old because they stop pursuing dreams.” Gabriel Garcí­a Márquez

Nassim Nicholas Taleb was asked whether public protests in Athens is a Black Swan Event. He replied: “No. The real Black Swan Event is that people are not rioting against the banks in London and New York.”

"Getting worse more slowly is not the same as getting better", Prof. Brad DeLong